How would you answer this question?

Q: If you owned shares in a company, and that company went bankrupt; would you A) wish that the company had paid you $100 in dividends while you owned the shares, or B) hadn’t paid any dividends at all?

I recently came across a modified form of this question in one of the numerous (& religious) Dividends Vs. Total Return posts over at the Bogleheads forum.

The answer’s pretty obvious right? The shares in both cases went to a value of $0. The dividend paying answer landed you with $100 in your pocket; the non-dividend paying answer gave you nothing.

So sign me up for the dividend stock which paid $100 in cold hard cash, thankyouverymuch! I’ll take answer A)!

Except like most things in life, it’s not that simple and the question is loaded.

Changing the question

Let’s rephrase the question slightly differently to illustrate a point:

Q: If you owned shares in a company, and that company went bankrupt; would you A) wish that the company had paid you $100 in dividends which you had reinvested in that same company while you owned the shares, or B) hadn’t paid any dividends at all?

Now with the revised question, in option A) I’m now happily re-investing dividends as they’re paid and they’re compounding all up until the time when the company goes bankrupt. So I own $0. And with B) I’m at $0 also. So it’s a wash really.

But we didn’t mention Taxes yet, and in a tax-advantaged account it really is a wash. If the shares were held in a Taxable account; then you may also have been required to pay taxes from the earned dividends. The better answer in that case is really B) – the non-paying dividend stock – there were no taxes owed and the same amount of money at the end of the day ($0).

Now before you cry foul; yes I changed the question. But I wanted to challenge the automatic A) answer that you might expect.

So why is answer A) better for the first question and answer B) better for the second question? After all dividends can also be re-invested in other stock, in which case you might still have $100 at the time of this fictitious bankruptcy (or maybe even more if the other stock grew). They can also be put under a mattress or spent; they’re so versatile!

Apples & Oranges

The difference is that the revised second question makes a fair Apple to Apple comparison. The first question compares an Apple to an Orange and doesn’t take the whole picture into account.

Investments in the stock market gain wealth from Capital Gains and Dividends. Together this is “Total Return”, since the amount of dividends that are paid over a long period of time are usually as of much interest as the increase in share price. And a lot of the overall wealth from the stock market comes from re-invested dividends; new shares acquired by re-investing dividends can themselves appreciate in price as well as pay more dividends and so the snowball is born.

The reason that the first question led to answer A) is that dividends aren’t free. When a company pays a dividend, its share price goes down a little bit by the amount paid. It’s usually not even noticeable since it’s lost in the daily fluctuation of share price. But had it not paid a dividend, its share price would be higher.

Taking things to extremes usually illustrates a point, so let’s do that with Apple which currently sits on a cash account of something like $61B. With a $570B market cap, this is around 10% of its total value. Its share price takes that cash buffer into account; and should it give that $61B away, its share price can be expected to drop. Now it might not drop the exact amount since many factors affect share price. Announcing a dividend payment may even increase share price more; but at the time of the payment, its share price would drop.

Another example could be taken from Warren Buffet. Berkshire Hathaway doesn’t pay any dividend – Warren Buffet explains why in his 2012 letter (page 20). Would BRK.A shares be worth $222,824 each today if the company had paid 5% dividends for each of the last 50 years instead of reinvesting that money? Of course not. Perhaps they’d be worth $100 but had you re-invested that fictitious 5% dividend in more BRK.A stock, you’d own a whole lot of $100 shares. And in this fictitious world, your brokerage balance wouldn’t be $222,824 either – but whether higher or lower it’s impossible to know.

Changing the Question … One More Time

Great – now I have a Britney Spears’ song stuck in my head. The things I suffer for blogging. But I digress. Let’s change the question one more time and compare Apples to Apples.

Q: If you owned shares in a company, and that company went bankrupt; would you A) wish that the company had paid you $100 in dividends while you owned the shares, or B) hadn’t paid any dividends at all but that you’d sold $100 of the shares before it went bankrupt?

Now the question is fair. Even though with answer B) the company didn’t pay a dividend; in theory there’s nothing to stop you from making your own dividend with option B) by selling stock. From a tax perspective option B) can be also more flexible since you can decide which lot of shares to sell.

In practice however, dividends are more convenient and don’t incur trading fees so I’ll let you chose your answer here.

The original question skips the point that since the $100 dividend wasn’t re-invested in the same stock, it was really a withdrawal of capital from the investment; that can be done at anytime by selling stock.

Since we’re comparing the same company in the question, let’s just state that, before things went so terribly wrong, it had a Total Return of 7% and that the dividend was 2%. So for answer A) that means the price increased 5% along with a dividend payout of 2%. For Answer B) that means the price increased 7%.

Selling 2% of the stock in answer B) ends up back at the same monetary value (but with fewer albeit more valuable shares) than answer A).

Why I still like dividend payments

I understand that since I don’t actually need “income” from my Income Fund on a monthly basis, that it would be more tax efficient to avoid a high-yield dividend index and just go with a total market account. I also don’t invest in dividend stocks because I think that their Total Return will beat the market; I’m interested in Income.

But I think there are still valid reasons why the practical benefits of dividend payments can outweigh the theoretical arguments. Many of these are also personal or situation specific, but they include

Convenience

I like dividends for the commission-free convenience of receiving income from my Income Fund. They’re paid automatically by bank deposit and doesn’t require any interaction on my part (at least for the investments I have at Vanguard; I still need to manually transfer dividends from individual shares in my Capital One account).

Yes, I could set up Vanguard to automatically sell a set amount of funds monthly but I’d still have to be involved with rebalancing. With individual stocks that’s not even an option at my brokerages.

It doesn’t work as well for individual stocks

You can’t sell partial shares. So when owning individual stocks, it may be impossible to withdraw (say) 2% of the invested capital. This does depend on how much stock you own however.

Imagine if I had bought one BRK.A share in 1962 (*) which is now worth $222,824, I would only have the option of selling that one single share. In other words, I could only withdrawing 100% of my capital rather than just 2%. Likewise if I had bought two shares, I could only withdraw 50% of my capital by selling one share.

(*) Aside from the minor detail of not being alive in 1962, I likely wouldn’t have been able to pick that one stock from all the others in the market.

Trading fees for sales

While you can pick and chose which stocks to sell for tax efficiency, there may still be trading fees incurred.

This isn’t an issue for index funds that don’t charge sales fees. The number of transactions could still be limited for individual stocks by selling quarterly or yearly.

Selling at low prices

Technically, receiving a dividend when a stock’s price is low, is equivalent to having sold it at a low price. But on a practical basis with a steady stream of dividends, I don’t even need to look at the share price or worry about it. Whereas with selling shares, I’d need to be monitoring that to determine how many to sell. Again this limitation is really only for individual stocks because of the partial share restriction – mutual funds don’t have this problem.

I can’t make the market stop paying dividends

There’s nothing wrong with dividends and companies will always pay them to return shareholder capital. Monetary or Tax policy may influence the popularity of dividends however. But if you only needed (say) 2% income a year and you were receiving dividends of 2% because the company pays them anyway, then it’d be pointless to invest that 2% only to turn around and sell it.

Summary

I’d just like to end this post by saying that:

Great Companies result from a combination of great products, process and people, plus Luck.

Not every Great Company pays a dividend.

Not every dividend-paying Company is Great (so choose carefully).

Your investing strategy should be based primarily around your objectives and personal situation / tolerance for risk.

Quote of the Day

It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

Related

8 thoughts on “How would you answer this question?”

I like the questions and difficulties you pose. I suppose ultimately we can talk about capital gain and/or dividends all we want. But ultimately we need to be a top down or bottom up investor (is in a good industry or does it have good fundamental financials?). Or perhaps both.

A company that re-invests a lot of its profit, at a high rate of return for those re-invested profits, where it’s a leader in an industry that has a long/growing future is the best way to go perhaps?

I love dividends, but I’d prefer less dividends and more company growth. If the company literally can’t re-invest that money for a good cause, then give me the extra.

Hi Tristan,
Yes I think you hit the nail on the head – the underlying business operation & fundamentals is the most important criteria. Companies can take on extra debt to fuel dividend increases / stock buybacks, so keeping an eye on the fundamentals is important.
Best wishes,
-DL

Ciao DL,
I guess that you are comparing two different things here, two different styles of investing. I do not think that one is better than another, I know that I prefer to have those 100 dollars to manage myself rather than trust completely a third party to do the job for me…

Hi Stal,
I wasn’t trying to compare investing strategies as much as highlight that dividends aren’t free and essentially represent a withdrawal of capital if not re-invested.

I understand the managing the money myself aspect – I think it’s a valid point although it’s not an important consideration for me personally. After all I must trust that leadership are making the right decisions to grow the company and increase any dividend payment to begin with. Trusting the management of companies you invest in is important – fortunately that trust can be verified to an extent via the balance sheet.
Best wishes,
-DL

These are great questions.
I thought about this a lot last week, and I agree that if a company goes under and you’ve reinvested everything, then you’re screwed. Also, there is no difference if a non dividend company offers buybacks that increases at the rate of dividends.
For me, one of my account doesn’t allow reinvestments so I invest selectively. In this case, the total return is based in the portfolio rather than individual stocks.
At the end of the day, it is about picking companies with strong growing earnings and revenues.

Hi D4S,
Your last statement about strong fundamentals says it all and I completely agree. I don’t automatically re-invest dividends back into the same stock either. In a taxable account it can even be better not to automatically re-invest dividends in order to reduce tax lots and avoid wash sale issues.
Best wishes,
-DL

Hi Doug,
LOL, yes option C is always preferred and again goes back to reviewing fundamentals. The bankruptcy aspect is really just there to emphasize the point that in answer A) there was capital withdrawal but none in answer B) so the original question isn’t a fair comparison.
Best wishes,
-DL

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